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FURTHER TO MONEY MANAGEMENT
My last commentary had to do with the importance of money management in your overall trading strategy. I can’t stress how important this is to your overall trading success. It’s just not good enough to rely solely on entry & exit strategies. You must be aware that it is more important to concentrate on what you do with your trading results. With the proper money management rules, you can turn a fair or average trading system into one that far exceeds your expectations.
Fixed ratio position sizing was introduced by Ryan Jones in his book “The Trading Game”. Money management, or trade sizing, can be tricky, and not all approaches are suitable. With this approach, the system you are trading does not have any importance in the determination of how many contracts you trade. Any trading system will benefit. This approach is based strictly on your equity balance. As the equity balance (your profits) improves and climbs, you trade more contracts. If your equity balance starts to fall, you trade fewer contracts until your balance starts to climb again, then you increase your number of contracts per trade.
This is called an “antimartingale” method, where the number of contracts increases as profits accrue and decreases as the equity drops during a drawdown. This approach is much better than the “martingale” method where the opposite is true – you increase the number of contracts as the equity drops and decrease the number of contracts as the equity increases.
So, money management is based on the increase or decrease of your trading account. Your trade size increases as your equity increases based on a pre-calculated mathematical process – fixed ratio method. As your equity decreases, your trade size should decrease based on your decision as to whether you wish to be on the safe side with less risk, or whether you want faster growth and therefore shoulder more risk .It all depends on your decision. In order to understand money management, you need to move away from the belief that it is somehow tied into what trading strategy or market or time frame you are trading. It is solely dependent on the increase or decrease of your account balance. It can be applied to all trading methods.
We referred to fixed ratio position sizing as the best approach, with the key parameter being the “delta”. This has to do with the dollar amount of profit per contract to increase the number of contract factors by one. A delta of $3,000 for example means that if you are currently trading one contract, you need to increase your account equity balance to over $3,000 to start trading two contracts. Once you get to two contracts, you need an additional $6,000 to start trading three contracts. Any equity balance below $3,000 profit and you trade only 1 contract. If your equity balance drops down one delta, the number of contracts you are trading also drops down - by one contract.
For the more adventurous traders, you can decrease the value of the delta. For those less risk prone, you increase the delta value.
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